The year-to-year
change in a bank's earnings per share (EPS) is driven by the fluctuating values
of nine critical ratios. This paper defines those ratios and shows how to integrate
them into a spreadsheet routine that will:

This analytical
technique is useful to both investors and managers. It quantifies for investors
the effect on EPS of past ratio changes, and it helps them evaluate the bank's
capacity for future earnings increases. It reveals to managers those operational
areas where improvements will yield the greatest bottom line benefits, and it
allows them to calculate the EPS effect of targeted ratio changes.

I.
Nine Critical Ratios

Definitions

A bank's EPS is determined by the interaction of nine critical
ratios, which we define in the following way.

Ratio 1: interest expense ÷ average liabilities—the average interest rate paid on total average liabilities.

Ratio 4: non-interest expense ÷ total revenue less interest
expense—commonly known as the efficiency ratio. A bank
with significant tax exempt interest income will sometimes increase the ratio's
denominator, total revenue less interest expense, adding to it the tax
benefit that results from exempt interest income. This adjustment produces
a lower—and, at first glance, better—efficiency ratio than the one calculated
by the standard method. We will avoid this needless complication. Any tax
benefit arising from exempt income will be readily apparent in the below-normal
tax rate calculated by the next ratio.

Ratio 5: income tax ÷ pretax earnings—the effective tax rate.

Ratio 6: total revenue ÷ average assets—the rate of asset turnover.

Ratio 7: average common equity ÷ average assets—the
common equity ratio. Changes in the common equity ratio will always be examined
in conjunction with changes in the preferred equity ratio (average preferred
equity ÷ average assets).

Ratio 8: preferred charges ÷ average common equity—the reduction in return on common equity arising from the payment of preferred
dividends and preferred stock retirement premiums.

Ratio 9: average common equity ÷ average common shares outstanding—the book value.

The Effect of Critical Ratio Value Changes on EPS

We shall
now see how the values of these ratios shaped the EPS change of a $66 billion
dollar bank holding company headquartered in the Midwest. The bank's annual
report shows that earnings for the latest fiscal year were thirty-one cents
per share higher than earnings for the previous fiscal year.

Using the
procedure explained below, we can trace those thirty-one cents back to specific
increases and decreases in the year-to-year values of the nine critical ratios.
As Exhibit 1, Column D shows (see below):

Ratio 1.The
average interest rate paid on total liabilities increased, costing about 27
cents per share.

Ratio 3.The percent of interest revenue
to total revenue increased, costing about one cent per share. (This is a roundabout
way of saying that there was a decrease in the percent of non-interest revenue
to total revenue. For mathematical simplicity, we use the percent of interest
revenue rather than non-interest revenue.)

When the
positive and negative effects of these ratio changes are summed, the result
is $0.31. Adding this amount to the Previous Year's EPS of $2.45, we arrive
at the Latest Year's EPS of $2.76. Let's find out how the figures were derived.